Over the years since the 2008 Recession I have watched as Annuities have gained in prominence. The rise seems to correspond with the increase of individual district of banks and the stock market. Frankly, Annuities are one of the worst type of investments you can buy. Today I’m going to tell you why you should never purchase an annuity.
Rise of the Annuities
Annuities are essentially contracts between you and an insurance company or investment company. You provide them a lump sum in exchange for them providing you payments or a lump sum sometime in the future. These payments can also be either a fixed amount or a variable amount. This means they either pay out the same amount regardless of situation or they pay out a different amount in that period based on some metric.
From what I can tell the big rise in annuity usage comes from those who want the fixed variety. People looking for a “Guaranteed” payout tend to purchase annuities rather then an investment in the market or bonds. They are viewed as set it and forget it investments with little risk. But is that true?
Why You Should Never Buy an Annuity
The first thing to realize about Annuities is as stated in my second paragraph they are a contract. By investing in an annuity you are incurring a counter party risk, which we talked about at length in the past. You are betting that the Annuity Company will be here to pay you when it is time to payout. Sometimes these also have some sort of secondary company backing their payments, which gives a second level of protection. However, at it’s root you are taking a bet and a risk that the company you purchase the annuity from will be here to pay out. Lest we forget many Mortgage Backed Securities had a second level company providing insurance over their payout. Those companies went bankrupt in 2009 and the owners were left holding the bag.
Annuities tend not to be liquid. If you invest in an annuity that returns 2% and the market starts returning 3% you can not just pull out and reinvest. If you need the money for some period you also cannot just up and sell and deploy the money. If there is a provision at all to get your money out it’s like with a hefty surcharge. I’ve seen rates well into the double digits for withdrawal.
Annuities tend to charge hellacious fees. Typically annuities are sold by insurance companies, not investment companies. They are doing so to make a profit. Furthermore their salesmen are likely making a giant commission cut. This is why he is pushing this pile of dung on you in the first place. Think about it, the only way the insurance company makes out on an annuity is if they make enough in fees to cover their payout, their profit, and their commission. They have to do so by investing in the same vehicles as you, the market and bonds. So in practice your Annuity is always going to have a return minus expenses situation well less then the market return over time. If not the annuity company would go out of business which brings us back to my paragraph on payout risk.
These instruments are also incredibly complicated. You should never invest in something you do not understand. These investments tend to be opaque with respect to costs, penalties, and even underlying performance measures.
Finally consider that payouts of Annuities often times cease upon death. Which means you are counting on living long enough to recoup even your original lump sum. There are no guarantees this will occur. Even inheritable annuities are not necessarily a great move, as unlike stocks you see no step up in tax basis on inheritance of an annuity.
Do you need a low risk portfolio allocation?
We’ve talked before that your asset allocation should feature lower returning but lower risk investments in correlation to your risk tolerance. The more risk intolerant you are the more return you would be willing to trade for lower volatility. If those funds keep you from selling at an inopportune time and allow you to sleep during the depths of a depression then they are well worth it. Obviously, taking too little risk will be suboptimal to your return, requiring you to work much longer. However there is some marginal utility to return where it holds less value then stability. This is the personal aspect of personal finance which is up to you to decide. However there are other ways to do that with higher guaranteed returns, lower fees, and less risk then an annuity. These might include savings bonds or a cd ladder for example.
These items are not sold by your insurance guy and have an out clause if you change your mind. After all as we discussed before Risk Tolerance and investment needs change throughout your lifetime. You need flexibility where possible, which is not going to happen with annuities. As such if your truly of the type that needs an extreme level of comfort with the risk of your investments then your better off with one of those other investments. There is no scenario I can foresee where I would choose an annuity. And hence my mantra is you should never purchase an annuity.
How do you feel about annuities? Do you hold any?